DealLawyers.com Blog

May 20, 2009

Due Diligence: Aim Before You Fire

– by John Jenkins, Calfee Halter & Griswold

Spearheading the legal due diligence investigation of a potential acquisition target is a big part of a deal lawyer’s job. With the possible exception of preparing disclosure schedules, due diligence usually is the most tedious part of the transaction, but it is also among the most important. That’s why the “ready…FIRE!!!…aim” mindset that a deal’s time pressure sometimes causes lawyers to adopt when it comes to due diligence is almost always counterproductive.

Time is invariably of the essence in a transaction, so there is great pressure on everyone to get moving – particularly if you’re talking about a big deal with a mountain of paper to review and little time to do it. There’s an overwhelming temptation to wade into the pile and start reviewing things before you’ve figured out what the deal is about. This leads to a disorganized process that produces incomplete or incoherent results. That can make it very difficult for your client to make decisions about valuation in a timely fashion, and in a competitive situation, can be fatal to its efforts to acquire the target.

UCLA’s legendary basketball coach John Wooden had what I think is the best advice for anyone dealing with time pressure situations – “be quick, but don’t hurry.” What he meant by this is that when the pressure is on, you’ve got to move fast, but you’ve also got to remain in control of your situation. I think the best way to apply Coach Wooden’s advice to a deal with a short fuse is not to start your due diligence before you’ve done some due diligence.

No, I’m not trying to follow up John Wooden with advice that sounds like its coming from the mouth of Lakers’ coach Phil Jackson. What I’m talking about is spending some time at the front end to convert a scatter-shot approach to due diligence into a more disciplined preliminary assessment of the issues you’re likely to encounter. Investing time in laying the groundwork for your due diligence can make the investigation more efficient, less burdensome to both sides, and more effective overall.

How do you go about doing this? If you’re dealing with a public company target, then the first step should be to spend some time with the target’s SEC filings. Many of the documents that you’re going to want to review are going to be in those filings, but more importantly, a company’s SEC filings contain a wealth of other legal, financial and business information about the target that will be very useful to you in mapping out a strategy for approaching due diligence.

If you’re not dealing with a public company, chances are still pretty good that it competes with companies that are public, and their filings may provide you with a lot of help in focusing your initial due diligence efforts. SEC filings are also a good place to start if you’re not buying the company itself, but only a subsidiary or a division. If the business is large enough or represents a reportable segment, those filings will contain a remarkable amount of financial and other information about the business your client is looking to buy.

Chances are also pretty good that your client has managed to get a copy of an investment banker’s book on the target or some other form of offering document. That usually has lots of useful information about the business, although in order to get at it, you usually have to wade through a mountain of marketing spin and banker-speak (e.g., “management has proactively leveraged the company’s market leadership and value-added manufacturing expertise to position its new proprietary product to capitalize on the anticipated explosive growth in demand for…blah, blah, blah”). Research analyst reports on the target or its industry can also provide a wealth of information on the financial, business and even the legal issues confronting industry participants, and contain a lot less spin than the marketing materials typically do.

A lot of deal lawyers do everything I’ve just described as a matter of course, but sometimes what ends up happening due to the press of time is that the SEC filings, research reports and banker’s books end up getting thrown on the junior lawyers desks as “background” for that person to read as they wade through the data room. Most younger lawyers are smart people, but it isn’t reasonable to assume that they will necessarily pick up on the critical issues in the deal without some additional guidance. If you don’t give them that, you can almost count on them mindlessly regurgitating lease terms into a dictaphone without giving any thought to what they are doing. This is how useless 250 page due diligence memos are born.

I think a much better practice is to sit down with the legal due diligence team, the business people and the client’s financial advisor before turning the junior people loose on the data room. That way, you’ve got a shot at making sure that the people who will be reviewing the documents are aware of what the deal is all about, and what the critical legal issues that might affect valuation or the ability to complete the transaction are likely to be.

This effort to plan out due diligence may take a little more time than simply tossing a handful of associates into the deep end of the virtual data room, but it is guaranteed to produce a more efficient process in the long run and to generate results that are going to add a lot more value to the client.